'Back at square one': Research shows the folly of cashing out of 401(k) when leaving a job

There are plenty of financial sins out there, including not saving enough, failing to take advantage of available tax deductions and spending lavishly on cars, clothing or vacations that you can’t afford.

But when it comes to misbehaving with money, it’s hard to top cashing out of workplace retirement plans and failing to get back in.

It's more common than you might think, and employers unintentionally might share part of the blame.

You can trigger significant tax and other costs when withdrawing money from 401(k) programs before retirement age. Yet 41% of employees cash out when they leave jobs, voluntarily or not, and most of these people drain their entire accounts, according to a new study conducted by researchers Yanwen Wang of the University of British Columbia, Muxin Zhai of Texas State University and John Lynch Jr. of the University of Colorado.

In preparing the study, called “Cashing Out Retirement Savings at Job Separation," the researchers evaluated the withdrawal patterns of more than 162,000 employees covered by 28 retirement plans, from 2014 to 2016.

“When people cash out, they are back at square one, with no more savings than they had when they started" a job, the researchers wrote in a prepared statement. "They set themselves back years in the ability to accumulate enough savings for a comfortable retirement.”

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Of the workers who tap into their retirement accounts upon separating from employment, 85% withdraw everything. American workers hold about 12 jobs over their lifetimes, staying with each employer for about four years on average, according to online job-search company Zippia, so there are plenty of opportunities to cash out.

This helps to explain why the median or midpoint 401(k) balance was only $27,376 in 2022, about the price of a newer used car, according to Vanguard's "How America Saves" report for 2023. The average balance was a more-respectable $112,572, boosted by the relatively small number of workers with hefty accounts. One in 3 workers has less than $10,000 in a 401(k), according to Vanguard.

Navigating withdrawal options

When leaving jobs, workers generally have four choices on how to handle a 401(k): Some employer plans will let departing workers leave their money in their plan. The other choices are: roll the balance to the plan offered by a new employer (if allowed), transfer the money into an Individual Retirement Account, or cash out.

Workers who cash out of traditional 401(k) plans must pay income taxes on the amount, in addition to a possible premature-withdrawal penalty of 10% (if taken before age 59 ½). “This means that people are losing an extra pile of their money on the way out the door by accepting a 10% penalty in the process," the researchers wrote.

Permanent withdrawals coming from regular 401(k) plans are subject to ordinary federal and, possibly, state taxes. Worse yet, even a medium-sized withdrawal could push you into a higher tax bracket, depending on your other income. And then there's that 10% penalty on withdrawals made before age 59 ½.

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Taxes and the penalty don't apply if you roll over, or transfer, the money to another tax-sheltered account, including IRAs, within 60 days.

Withdrawals of Roth 401(k) contributions (those on which you didn't receive a tax deferral when you contributed money) typically come out tax-free, though the 10% penalty can still apply. The tax rules can get complicated quickly, and there are various exceptions. But younger workers cashing out of a 401(k) should beware of a tax bite when leaving a job.

Are employers doing enough?

The propensity to cash out increases when workers have received higher amounts of employer contributions or matching funds, according to the study. The larger the proportion of an account balance that was contributed by the employer, the more workers treat it like a windfall that they feel justified to spend, overlooking or ignoring the tax consequences.

This has implications for employers that set up retirement accounts and chip in money in hopes of helping employees improve their long-term financial situations. However, employers generally don't view cashing out as a pressing issue, the researchers said.

“Most firms have a blind spot about what happens at job termination and offer no financial advice to departing employees,” they wrote. Instead, employers typically delegate responsibilities to whichever financial services company administers their 401(k) plan. These entities send out standardized letters to departing employees, informing them of their options without providing real guidance, the researchers said.

Many departing employees apparently view cashing out as the easiest choice – simpler than rolling over the balance into another employer plan or an IRA and then deciding on a new lineup of investments.

When departing employees view that cash-out check as a windfall rather than their own hard-earned money, they are less likely to put in the added effort of setting up a new account and choosing investments for it. It’s hard not to see the behavioral similarities to people gambling more aggressively when they are playing with house money.

“If firms could deter departing employees from suddenly eyeing their hard-won savings as a free-money windfall, those higher employer match rates would generate the full benefit intended to help the employee retire comfortably,” the researchers wrote. “While employers mean well . . . they may in fact be unintentionally nudging employees to cash out."

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